After RBI surprise on govt paper sales, bond yields spike over liquidity fears

The yield on benchmark 10-year government bonds shot up by 12 basis points to 7.34 per cent, the highest level since March 23. The benchmark Sensex rose by 0.55 per cent, or 364 points, to 65,995.63.

Highlights of the Monetary Policy announcement today by Governor Shri @DasShaktikanta. #rbi #rbitoday #rbigovernor #rbipolicy #monetarypolicy #rbimonetarypolicy #shaktikantadas pic.twitter.com/ucXMgf4O4G

— ReserveBankOfIndia (@RBI) October 6, 2023

According to SBI Caps, a closer examination showed RBI’s commitment to assertive control over liquidity dynamics and its vigilant approach to addressing inflation. In pursuit of these objectives, the RBI has signalled it may employ unconventional measures like OMO bond sales through the auction route, when deemed necessary.

ICRA Analytics foresees the 10-year benchmark yield to trade between 7.25-7.40 per cent in the near term. While a tight liquidity position will help bring down inflation, it puts upward pressure on interest rates.

The decidedly hawkish market response came despite the absence of major revisions to economic projections and the decision to maintain existing interest rates.

Now, RBI emerges as a new supplier of government bonds. While there is no explicit timeline for this, an apprehension remains that such OMOs can be announced any day. “This is especially so since the market understands that the best of liquidity is likely over October-December quarter. Core liquidity may shrink enough by then for the RBI to not want to persist with OMOs from the next quarter. Thus, the risk of this additional supply is more near term, and this may weigh more on the minds of market participants,” said Suyash Choudhary, Head, Fixed Income, Bandhan AMC.

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— ReserveBankOfIndia (@RBI) October 6, 2023

In Mumbai, Das said: “Festival time increase in currency demand may, of course, act as a counter balancing factor. It is a turning pitch and we will play our shots carefully. Going forward, while remaining nimble, we may have to consider OMO sales to manage liquidity, consistent with the stance of monetary policy.” The timing and quantum of such operations will depend on the evolving liquidity conditions, he added.

The market was not expecting this measure from the RBI to suck out excess liquidity. Due to the forthcoming festival season, liquidity is expected to tighten due to cash withdrawal from the banking system, said Murthy Nagarajan, Head, Fixed income, Tata Asset Management.

The RBI’s retail inflation forecast for at 5.2 per cent for the first quarter of FY25, coupled with the governor’s emphasis on the target level of 4 per cent rather than the 6 per cent band, is seen as a hawkish message, aligning with the stance of “higher for longer”.

As per market estimates, core system liquidity is of the order of Rs 325,000 crore after the I-CRR (incremental cash reserve ratio) unwind. However, currency in circulation is expected to rise by Rs 225,000– 250,000 crore by the end of March 2024, as per normal seasonal trends. Further, the balance of payment has been quite healthy over the first half of the year and is unlikely to be the same over the rest of the year. “While this is speculative and difficult to model, but already RBI’s dollar sales have picked up. The point we are making is that, in all likelihood there is no reason at all to take permanent measures on liquidity mop up given that most of the core liquidity surplus is already poised to vanish by the financial year end,” Choudhary said.

“The bother really is the time it takes for this to happen and that is why the temporary measures made perfect sense and the permanent measures (like OMO sales) don’t. The other argument is that, despite denying it publicly, RBI actually wants yields to adjust higher, probably reflecting the rise in global bond yields. We are less inclined to go with this argument since at best it is a slippery slope to manage for the central bank,” he said.